CAIN: Democratic Dialogue: Hard Choices: Policy autonomy and priority-setting in public expenditure (Report No. 10)

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Hard Choices

Policy autonomy and priority-setting in public expenditure


Bang for the buck

Vani Borooah[1]

The last three decades saw the emergence, in the major industrialised countries, of the growth of government. Governmental activities came to play a major role in economic affairs.

Table 1 shows government expenditure as a percentage of gross domestic product in seven countries of the Organisation for Economic Co-operation and Development, for selected years during 1960-90. In each case, this proportion was higher in 1990 than in 1970, and considerably greater than in 1960.

Table 2 shows the shares, in GDP, of the main economic categories of government expenditure for five countries (UsA, Japan, Germany, France and the UK) for the years 1979 and 1990. Two items dominate:

  • cash transfers to the personal sector, mainly as pensions and other social security benefits, and
  • government consumption of goods and services, itself dominated by the public-sector wage bill.

The largest item in all cases was spending on income transfers, varying from 32 per cent of government expenditure in the USA and the UK to nearly 40 per cent in Germany These were, in turn, dominated by transfers for income maintenance, predominantly retirement pensions.

Table 1: government expenditure as proportion of GDP
in seven OECD countries (%)

1960
1970
1980
1990
United States
27.7
32.4
33.7
37.0
Germany
32.0
38.6
48.3
46.0
France
35.7
38.9
46.1
50.4
United Kingdom
32.4
39.0
44.6
42.9
Italy
32.1
34.3
41.7
53.2
Canada
28.9
35.7
40.5
46.4
Sweden
31.1
43.7
61.6
61.5
Unweighted average
31.4
37.5
45.2
48.2
Standard deviation
2.6
3.7
9.1
7.8
Source: OECD, National Accounts

Table 2: government outlays by economic category (% GDP)

.
United States
Japan
Germany
1979
1990
Change
1979
1990
Change
1979
1990
Change
Total current disbursements
30.4
35.2
4.8
23.9
24.7
0.8
42.4
42.3
0.0
Government consumption
17.0
18.3
1.2
9.7
9.0
-0.7
19.6
18.5
-1.1
Subsidies
0.4
0.2
-0.2
1.3
0.7
-0.6
2.2
1.9
-0.3
Social security and other transfers
10.2
11.5
1.3
10.3
11.2
1.0
18.9
19.3
0.4
Debt interest payments
2.8
5.2
2.4
2.6
3.8
1.1
1.7
2.6
1.0
Government investment
1.7
1.6
-0.1
6.3
5.0
-1.3
3.2
2.3
-1.0
Capital transfers
-0.4
-0.2
0.1
0.5
0.0
-0.4
1.8
1.1
-0.6
Other transfers
-0.1
0.4
0.5
0.9
1.0
0.1
01
0.1
-0.1
Total
31.7
37.0
5.2
31.6
30.7
-0.9
47.6
45.8
-1.8

continued....
.
France
United Kingdom
1979
1990
Change
1979
1990
Change
Total current disbursements
41.4
46.6
5.2
39.2
38.1
-1.1
Government consumption
17.6
18.3
0.7
19.7
20.0
0.3
Subsidies
2.0
1.6
-0.3
2.4
1.1
-1.3
Social security and other transfers
20.4
23.5
3.1
12.8
13.7
0.9
Debt interest payments
1.4
3.1
1.7
4.4
3.4
1.0
Government investment
3.1
3.3
0.2
2.6
-2.1
-0.5
Capital transfers
0.4
0.2
-0.2
0.7
-2.9
-3.6
Other transfers
0.1
0.1
0.0
0.0
0.0
0.0
Total
45.0
50.2
5.2
42.5
42.9
0.3


Many economic and political commentators came to regard this with some alarm. Indeed, since about 1980, most government thinking in the OECD countries has reflected the view that the economic frontiers of the state should be rolled back. On becoming British prime minister in 1979, Margaret Thatcher signalled the start of the 'Conservative revolution' in economic policy which, with the subsequent elections of Ronald Reagan as US president and Helmut Kohl as German chancellor, quickly spread beyond the UK.

One of the tenets of this revolution was that there was a need for less, not more, government. Even today, Conservative attitudes to public expenditure hold sway in Britain: the new Labour government has devolved monetary policy to the Bank of England, adhered to the 'golden rule' of borrowing only what is necessary for investment, kept the ratio of debt to GDP prudently stable and not pursued any major redistributive policies. All of this has led the Economist to argue that "judged by his record so far Mr Blair is proving a pretty good Tory".[2]

The intellectual bases for this economic conservatism lie in the writings of Adam Smith and Milton Friedman. At a macro-economic level, Friedman argued that all attempts by government - through expansionary fiscal or monetary policies - to keep unemployment below its 'natural' rate would only offer a temporary palliative at the expense of long-term increases in inflation. The policy implication of this analysis was that the solution to high unemployment lay in 'supply-side' measures aimed at reducing the 'natural' rate.

At the level of micro-economics, Smith had argued that an 'invisible hand' brought order and consistency to the seeming chaos of the multitude of individual actions. It is this invisible hand which today's economists and policy-makers term the 'market' and the thrust of economic theory, of the textbook variety, has been to show that, under certain conditions, market outcomes are 'efficient'. The institutional backdrop for realising this efficiency is competitive markets. The appropriate micro-economic role for government, therefore, is to remove barriers to competition. At a practical level this has meant transferring-through denationalisation deregulation and contracting out-responsibility for several economic functions from the public to the private sector.

A rise in the proportion of GDP accounted for by government expenditure will be inevitable if growth of the latter outstrips that of the former. Even if real government expenditure and real GDP grew at the same rate, however, differential productivity growth between the public and private sectors would ensure that, in nominal terms, government expenditure as a proportion of GDP would rise. This 'relative price effect' occurs because while rising productivity gains, to some extent, offset the increasing cost of labour in the private sector it is conventionally assumed that there are no such gains associated with the public provision of goods and services.

There is, of course, nothing inevitable about such a rise: it relies on wage-growth parity between public- and private-sector workers. Nor is it inevitable that productivity growth in public goods and services must always be zero: the conventional wisdom is based on studies conducted in the 60s and 70s.

On the face of it, very little changed in the UK public sector over the 80s: it employed 5.4 million people at the beginning of the decade and about 5.2 million at its end. But there was considerable change in attitudes to work practices, whereby "choice, standards and quality [were now] the catchwords; flexibility, performance and local management the tools; the private sector the model".[3] These changes were particularly marked in four areas: pay determination, performance incentives, flexible working practices and local management.

Moreover, the setting of objectives and targets, allied to the devolution of management responsibilities, became widespread in the public sector. Indeed, the major innovation in the public sector in a number of OECD countries has been this new public management'. NPM attempts to improve the efficiency of public-sector organisations by applying private-sector principles of management; these emphasise competition between decentralised units. and maximum outsourcing of activities. Taken together, these changes imply that the basic assumption underlying the relative price effect-that productivity in the public sector grows more slowly than in the private, but that wages grow at the same rate - should, in the changed climate of the past decade, be treated with some caution.

Another set of explanations for the growth of public expenditure comes from public-choice theorists. They argue that government, like any other economic agent, pursues self-interest and that the self-interest of governments leads them to increase their expenditure. First, there is the electoral interest: for example, widening of the suffrage has led to the less well-off exercising their electoral power by voting for more egalitarian policies, involving higher welfare expenditures.

Secondly, interest groups demand increases in spending on specific items and! or new spending programmes. The gain from these programmes is visible and, at least, attracts the votes of those who demand them; the loss, in terms of the higher taxes and/or borrowing required to pay for this expenditure, is less visible and more diffused, since borne more broadly as higher rates of tax or interest. This can be associated with middle - and upper - income support for higher spending. British research has shown how professional and managerial families make disproportionate use of education and health services-they are more aware of their importance and live longer than working-class families-in addition to being major suppliers of them (as doctors, teachers and so on).[4]

Thirdly, the prestige of ministers and civil servants is intimately connected to the resources they garner for spending programmes within their departmental brief. As Ferdinand Mount has observed, "Bureaucrats cannot help becoming rent-seekers, in just the same way that entrepreneurs cannot help becoming profit-maximisers. It is their occupational deformation to regard the size, financial resources and morale of their department as intimately connected with the public good."[5]

Growth in public expenditure has been concentrated in the three big social programmes: social security benefits (including pensions), health and education. Since expenditure on these items is related to exogenous influences - demography and the state of the economic cycle-there has been a sense of helplessness on the part of governments in the face of ever-expanding public-spending figures.

The main force behind this expansion has been an ageing population. In every OECD country the 'support ratio'-working-age individuals divided by those over 65 - is predicted steadily to decline. In the UK it is likely to fall from 4.2 in 1980 to 3.1 by 2040.

This has two implications. First, there is upward pressure on health-care costs: average costs for over-75s are nine times as great, and for those between 65 and 75 four times as great, as for individuals of working age.

Secondly, under a pay-as-you-go pension scheme-where each generation effectively pays the pensions of the preceding one-proportionately fewer employees meeting the pension needs of retirees may require rising public-expenditure commitment. Labour-market trends, particularly the higher participation of women, have also had profound consequences, inflating the number of prospective pensioners.

Demography also plays an important role in education expenditure-this time reducing the pressure for spending on compulsory schooling, via falling fertility rates in most OECD countries. But this factor has been offset by increased participation in post-compulsory education, associated with rising educational qualifications - reflecting a realisation by governments that improved education and training are essential for industrial competitiveness. Thus, overall, real spending per student has continued to grow.

Lastly, the state of the economy has itself a major influence upon social-security expenditure. This goes beyond the payment of benefits to the unemployed. In the UK, and especially in Northern Ireland, aggravating the problem of unemployment is labour-market inactivity: the fastest growing component of the social-security budget in the past 15 years has been invalidity benefit.

In sum, therefore, much of the growth in public expenditure in OECD countries might be explained by demographic and social factors, generating a 'demand' for certain types of expenditure (both final and transfer). The sources of this demand lie in increasing claimants and a desire for higher standards of provision. Overlying this trend are cyclical movements linked to economic depression. In democratic societies, public-expenditure decisions, however benignly motivated, cannot be separated from what the public wants: governments choose to meet demand because, in large part, it is in their political interest to do so.

But these trends, if unchecked, would have meant that by this decade in some countries public expenditure would have accounted for more than three quarters of GDP. That this did not come to pass was due to mounting fiscal crisis, as voters became increasingly averse to funding the increases in taxation rising expenditure demands required.

The revolt of the tax-payers provided the catalyst for a dramatic reversal of attitudes towards public expenditure: instead of being seen as an instrument of good, as it had been from 1945 to 1974, it came to be seen in the 80s and the 90s as a harmful economic influence. Politicians in several countries have since campaigned on the promise of 'no new taxes'. Labour's defeat in the British general election of 1992 was widely ascribed to its proposal to put up marginal tax rates; Tony Blair was (and remains) desperate to convince the electorate that it need not fear taxes going up under new Labour.

In other words, there has been a dramatic change in the market for votes. As Tyrie observes, the median voter is likely to be a white-collar home-owner who is aware of, and anxious about, his tax burden.[6] All parties are fearful of being branded as high-tax and the question 'where will the money come from?', which inevitably greets any policy proposal that involves new monies , has made parties circumspect about what can be achieved through the public purse.

Changes in the political market-place have brought changes in the rhetoric of politics. Gone is the vision of the Great Society, where wise and generous public spending would be the rising tide that lifted all boats. In its place is a society which 'understands less and blames more'. The welfare state is charged with creating incentives which lead to social pathologies: single motherhood, weak labour-force attachment and crime are due to a state which rewards, or does not adequately punish, deviant behaviour, it is said; high tax rates and state encroachment in the economy sap incentives and enterprise and make for inefficiencies.

Current intellectual fashion plays down the role of the state in promoting good economic performance. Instead, attitudes towards government spending are couched in terms of 'restraint' and 'priorities'. Even if 'rolling hack the frontiers of the state' may be too extreme for some, expanding these frontiers appears undesirable to all.

In response to the fiscal crisis wrought by growing public expenditure, governments have taken action on three broad fronts:

  • reduction in the scale of state activity through cuts in public expenditure;
  • reduction in the scope of state activity through privatisation and contracting out; and
  • improvements in the efficiency of state activity through NPM.

Achieving significant, real cuts in public expenditure is extremely difficult. In the UK, nearly half of all expenditure consists of transfer payments made in response to demographic (old-age) and economic (unemployment) contingencies. That part spent on publicly-provided goods and services is constrained by party commitments ('the National Health Service is safe in our hands') or susceptible to threats of industrial action by powerful public-sector unions. As a consequence, such public-expenditure cuts as are attempted fall on the less visible parts of the budget, which usually means capital expenditure.

Nevertheless, major changes have been attempted. Linking state pensions to prices rather than wages, and equalising the state pension age at 65 for men and women, has saved about £8 billion. Non-pension transfers have been pruned through rule-tightening-such as reduction of the duration of what was unemployment benefit from 12 to six months-and bearing down on benefit fraud.

As regards public-sector pay, the monolithic structure of wage negotiations has been broken down - for both occupations and regions. For example, teachers, dentists, doctors, nurses, paramedics and senior civil servants are all subject to independent pay reviews. Meanwhile, performance-related pay is spreading downwards from senior management.

A start has also been made on zero-based budgeting. Every few years, each spending department in the UK undertakes a root-and-branch review to see if its spending programmes are still needed and, of those that are, whether they could be delivered more efficiently

In 1992 alone, across the world, $69 billion worth of state-owned firms passed into private hands and, if planned privatisations materialise, this figure could double by 2002. Indeed, a policy which, in 1983, appeared heretical to all but the most radical believer in free markets is today conventional wisdom.

Privatisation policies were pioneered in the UK and pursued so vigorously by the successive Conservative governments elected from 1979 that there is little left to sell. Today, every public utility in England is privatised - British Telecom in 1984, gas in 1986, water in 1989, electricity in 1990 - and the government has divested itself of ownership in several areas of industry. By 1996, the proportion of GDP resulting from the activities of publicly-owned enterprises had fallen to just 2 per cent.

But this was by no means only a British fashion. The French privatisation programme, legislation for which was passed in June 1993, expects revenues of $50 billion through the privatisation of 2l state-owned firms. The Italian government hopes to raise $10 - is billion through its privatisation programme.

In the past five years, however, the centre-stage for privatisation has shifted from Europe to Latin America: in 1992, this region accounted for 35 per cent (compared with only 6 per cent in 1988) of the total value of privatisations in the world. Even this may be dwarfed by privatisation in eastern Europe and the countries of the former Soviet Union: in 1992, with its privatisation programme still not fully under way, this region accounted for 32 per cent of the total world value of privatisations.

A further reduction in the role of the state has come from the contracting out of functions previously performed within the public sector: cleaning, catering, security and so on. Of course, from a social point of view, privatisation and contracting out offer no advantages (in terms of resource savings) unless accompanied by greater efficiency and without dilution of the quality of the product.

Vickers and Yarrow have argued7 that when privatisation was applied in the UK to industries in reasonably competitive markets, the policy was a success. It was, however, less successful when applied to firms with monopoly power. First, the obstacles to entry into these industries continued even after privatisation. Secondly, problems of access by the regulator to good-quality information meant that the regulated firms had considerable influence on the formula governing their prices. Thirdly, the focus of regulation has been entirely on price and has ignored regulatory incentives for investment behaviour - a point with particular force for the water industry, given the expensive investment needed to bring water and sewerage standards up to EU environmental requirements.

A basic rationale for government intervention in the economy remains, however - the notion of market failure, recently extended to embrace the process of economic development. Interest in the role of government as a catalyst for economic growth is derived from the observation that in most of the world's most successful economies governments have played an active role in guiding the course of economic development.

It has been argued that the development task facing countries today is different from a century ago. Then it was one of invention and innovation; today it is imitation and adaptation. This requires committing current resources to producing future and uncertain output. The risk is of otherwise missing potential markets and it is this which provides the basis for, and direction of, government intervention.

The creation of 'future-oriented' institutions is particularly important in manufacturing. This stems from the nature of modern industry, with its requirements of large-scale investment, specialised and lengthy training for managers and workers, competitively priced inputs and access to foreign markets.

Investment requires financial institutions that will lend long-term at competitive interest. Training needs government underwriting to overcome fears by firms that their training expenditure will be wasted if trained workers are poached by others. Competitively priced inputs require wage-negotiation machinery such that pay does not grow faster than productivity - as may happen under 'free collective bargaining'. And access to markets requires that the exchange rate be kept low and stable.

The role of state intervention in the economy is one of the oldest debates in economics. It revolves around three questions: when, where and how much to intervene. It is recognised, however, that it is the quality, not the quantity, of intervention that is important. It is differences in quality that explain why large-scale state intervention has proved disastrous in Latin America and in the erstwhile countries of the Soviet bloc, yet so successful in Japan, Taiwan and Korea - prior to the recent global travails which have hit both sets of countries indiscriminately.

In Northern Ireland, high rates of unemployment-with over half the unemployed long-term unemployed - mean that market failure is most starkly revealed in the difficulties the unemployed have in finding jobs. A major risk the Northern Ireland economy faces, therefore, is that a significant proportion of its population remains socially excluded.

The terminology of 'work-poor 'households, in which there are no earners - as against the 'work-rich ' households, which have more than one - has already entered the vocabulary of politicians. In the UK, the proportion of work-poor households increased from 6.5 per cent in 1975 to 18.5 per cent in 1994; meanwhile, the proportion of work-rich rose, more marginally, from 56 to 60 per cent.

As joblessness has become concentrated in particular families, so has income inequality between households grown - a problem exacerbated by widening individual inequality between skilled and unskilled among those in work, and by the concentration of poor families in particular neighbourhoods and housing estates. The socially excluded lack (or, at least, do not display) the social and cultural skills, and values, of mainstream working-class and middle-class people and may adopt a life-style 'normal' society would regard as 'undesirable'. The low incomes associated with unemployment or unskilled employment increase the attractiveness of illegal and even criminal activities.

Moreover, unemployment reduces the 'marriageability' of young men. Men who cannot support a family are unlikely to form one, while women who can support themselves - and any children they might have - find that being single "shields them from the type of exploitation that often accompanies the sharing of limited resources ".[8] Indeed, while unemployment amongst unskilled men has risen, the rise in women's employment - coupled with the fact that a woman is often better off as a lone parent than living with an unemployed man - means women have less need for economic support from men today than they did, say, 20 years ago. Result: many men can't marry, many women won't marry.

Furthermore, social exclusion may itself enhance the problems of male joblessness, as persistent poverty and chronic unemployment express themselves in 'perverse' behaviours inappropriate to entering the labour market, with its requirements of self-discipline and self-respect.

There is no single criterion by which people are socially excluded. Unemployment may exclude an individual from the world of work. Poverty (often, but not necessarily, a consequence of unemployment) may exclude a person from the world of consumption and social intercourse. And these facets have effects, perhaps conflicting: a single parent included in the world of work under threat of loss of benefit may still feel excluded from the domain of the family.

All in all, it is in the arena of social exclusion that public expenditure, and the energies of policy-makers and their advisors, need most to be directed.[9]


Footnotes

1 This paper was written while I was a visiting fellow at the Policy Institute, Trinity College, Dublin and I am grateful to the institute and the college for providing me with research facilities.
2Economist May 2nd 1998
3See Andrew Adonis' related series of articles in the Financial Times, July-August 1991.
4J Le Grand and D Winter, 'The middle classes and the welfare state under Conservative and Labour governments', Journal of Public Policy, vol 6,1987, pp 399-430
5F Mount, The British Constitution Now, Mandarin, London, 1992
6A. Tyrie, The Prospects for Public Spending, Social Market Foundation, London, 1996
7J Vickers and G Yarrow, Privatization: An Economic Analysis, MIT Press, Cambridge, Mass, 1989
8 W J Wilson, When Work Disappears, Albert A Knopf, New York, 1996
9A raft of detailed policy proposals is contained in Social Exclusion, Social Inclusion, Democratic Dialogue report 2, Belfast, 1995.

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